Eurodollar yields and a twisted curve

As part of its effort to stimulate economic growth, the Federal Reserve recently has invested its funds in longer-term securities rather than concentrating on the short-term end of the yield curve. Greatly reduced short-term rates over the past several years have not had the economic effects that were expected of them, and this has resulted in a certain amount of frustration by the central bank. After all, one of its roles is to support and promote sustained economic growth, and that has been hard to come by recently.

Richard W. Fisher, president of the Federal Reserve Bank of Dallas, has questioned the need for additional liquidity, pointing out the trillions of dollars of excess bank reserves on deposit at the Fed and additional trillions in the hands of corporations and money market funds. In essence, current monetary policy illustrates the maxim that “you can’t push on a string.” It is easy for the Fed to pull down a surging economy but difficult to reverse the process.

Over the past several years, interest rate forecasters frequently have noted that higher rates are just around the corner, having dropped so low that the only way is up. However, with the economy still wallowing in liquidity, rates remain incredibly low.

One way to measure the impact of Federal Reserve policy, and to describe the condition of interest rate markets, is to look at the yield curve generated by Eurodollar futures, an excellent proxy for the U.S. Treasury yield curve through the first 10 years of yield-to-maturity.

Eurodollar yields are calculated from the quarterly rates on futures contracts as a progression of geometric mean rates. The resulting curve is close to the U.S. Treasury yield curve because of constant arbitrage trading between Eurodollar futures, interest rate swap futures and Treasury note futures.